Butterfield Private Bank sees the long and short of it

Perhaps the most surprising aspect of the recent falls in equity markets was that they seemed to come as a complete shock to many, says Butterfield Private Bank in its latest investment views.

The VIX index (aka the “Fear Index”) measures expectations of volatility in US equities. It can, therefore, be quite a volatile figure itself as sentiment swings between Greed and Fear. In 21 years, the VIX has risen by more than 35% in any one day only 8 times: three of those occasions occurred in August 2011. By that measure, last month’s falls came as more of a shock than the weeks following the collapse of Lehman during the autumn of 2008. During that period, the US equity index saw 5 of the 7 biggest one day falls since 1990 – but on no day did the VIX jump enough to make it into the “35 Club”.

This suggests some form of “snap back” rally is likely, although questions remain over not just its timing but its durability: the sell-offs saw much higher volumes of shares traded than the subsequent bounces.

Short term trading considerations aside, there are fundamental concerns to address, foremost of which is the state of the economy. With recovery appearing to have ground to a halt, forecasts for growth have been cut dramatically in recent weeks. The Organisation for Economic Development (OECD), for example, reduced its 2011 forecast for GDP growth in the G7 excluding Japan (to little more than 1% annualised, versus the near 4% figure seen at the start of the year). Is this merely the beginning of a slide back into recession? In some ways, the issue is moot. The momentum of current trends, and the effect on business and consumer confidence of the summer’s stock market storms, means it is entirely possible the UK and European economies may dip into slightly negative growth before the end of the year (the Club Merde economies are, of course, already there). Given the extent of revisions to data from earlier in the year, and the current minimal level of reported growth, history may even show we are already in recession. As noted last month, forecasts of record profitability for the corporate sector are inconsistent with this economic reality, and the next few months will likely see a steady stream of analyst downgrades for European equities in particular. Such an outcome would be consistent with our expectations and our equity strategy.

More important would be if the US economy were to fall back into recession. Releases in July and August of “hard” data (recording actual economic activity rather than surveys of sentiment) were not unreasonable, but obviously recorded what the environment was like before the steep falls in stock markets over the summer. The sentiment based surveys during August were significantly worse. There are a number of factors which probably aggravated already downbeat sentiment, including the debt ceiling wrangles and the S&P downgrade of sovereign debt in the US and the slow motion train wreck that is the Eurozone. Consumer and business confidence is now so weakened, it is almost inevitable actual economic activity will similarly suffer over coming months and “hard” data releases will paint an increasingly gloomy picture. But it remains our central view that a severe downturn in the US is still not the most likely outcome, and we even expect economic growth to pick up somewhat. There are a number of reasons driving this relatively optimistic view.